Specialised Investment Funds (SIFs): Structure & Taxation in India

Specialised Investment Funds (SIFs) are a newly introduced investment vehicle in India by the Securities and Exchange Board of India (SEBI) to bridge the gap between traditional mutual funds and more flexible but complex alternatives like Portfolio Management Services (PMS) and Alternative Investment Funds (AIFs). Their structure and taxation offer a unique blend of flexibility, transparency, and tax efficiency for sophisticated investors, particularly high net-worth individuals (HNIs). This blog explores how SIFs are structured and how taxation of returns is handled under Indian regulations.

SIFs are regulated under SEBI’s Mutual Fund Regulations but are designed to allow asset management companies (AMCs) to pursue more sophisticated investment strategies similar to hedge funds or PMS portfolios. This includes equity long-short, sector rotation long-short, debt long-short, and other hybrid strategies with derivatives like futures and options. The minimum investment amount for a SIF in India is ₹10 lakh per investor, targeting accredited and sophisticated investors willing to accept higher risk and lower liquidity in exchange for potentially higher returns.

Unlike traditional mutual funds with standardized schemes and daily liquidity, SIFs offer more discretion to fund managers in portfolio construction and risk exposure, including limited ability for unhedged short positions up to 25% of net assets. The structure typically involves a sponsor at the top, a trust housing multiple schemes including various SIFs, and an AMC responsible for executing strategies, managing risk, and investor communications.

SIF Taxation Structure in India

Pass-through Taxation

SIFs benefit from pass-through taxation meaning the fund itself is not taxed at the fund level. Income and gains are taxed only at the investor level. This is similar to mutual funds which enjoy an exemption under Section 10(23D) of the Income Tax Act. In contrast, Category III AIFs pay tax at the fund level on income earned, often at the highest marginal tax rate applicable to business income, which reduces net returns to investors.

Taxation of Capital Gains

Taxation on returns from SIFs depends primarily on the nature of the underlying asset and the holding period. This is broadly categorized as equity-oriented funds or debt/hybrid funds:

Equity-oriented SIFs:

• Gains from sale of equity instruments held for more than 12 months qualify as Long Term Capital Gains (LTCG) and are taxed at 12.5%, similar to equity mutual funds.
• Short Term Capital Gains (STCG) on equity holdings (held for 12 months or less) are taxed at 20%.

Debt-oriented and other asset classes:

• LTCG on debt or non-equity holdings (held for more than 24 months) is taxed at 12.5%.
• Short term gains or gains on holdings under 24 months are taxed according to the investor’s applicable income tax slab rates.

For other assets like commodities or strategic derivatives within a SIF, LTCG taxation similarly applies after a 24-month holding period at 12.5%.

Dividend Distribution Tax

Dividends distributed by SIFs to investors are not subject to Dividend Distribution Tax (DDT) at the fund level since this tax was abolished in India in recent years. However, dividends received by investors are taxable as per their individual income tax slab rates.

Practical Tax Example

Imagine you invest ₹10 lakh in an equity-oriented SIF and ₹10 lakh in a Category III AIF, each generating a 15% return in one year.

• In the SIF, STCG is taxed at 15%, resulting in an after-tax return of approximately 12.75%.
• In the AIF, the gain is taxed as business income at say 30%, resulting in an after-tax return of around 10.5%.

Thus, the SIF saves the investor significant tax, making net returns more attractive after-tax considerations.

Key Considerations for Investors

• Liquidity: SIFs are generally less liquid than mutual funds, with restrictions on redemption frequency and potential lock-in periods.
• Minimum Investment: ₹10 lakh minimum, making it suitable for HNIs and institutional investors.
• Risk: Higher risk than traditional mutual funds due to more aggressive strategies and lower liquidity.
• Transparency and Regulation: While SIFs are regulated by SEBI and have governance comparable to mutual funds, disclosure and transparency norms may be less stringent than liquid mutual funds.
• Professional Management: Managed by licensed AMCs, ensuring a professional approach to complex strategies not possible in retail mutual funds.

Conclusion

SIFs in India represent a hybrid investment vehicle balancing flexibility, regulatory oversight, and tax efficiency. However, for investors interested in exploring SIFs, consulting a tax advisor and reviewing the specific fund’s strategy, risk profile, and redemption terms is crucial before committing capital.

This new asset class is poised to reshape how savvy investors access nuanced investment strategies in India with clarity and efficiency in taxation—making them a noteworthy consideration in portfolio construction.